Transcript

Jessie Romero: Hi, I'm Jessie Romero, director of research publications at the Richmond fed. Thanks for listening to "Speaking of the Economy," which you can subscribe to in Apple Podcasts.

I'm talking today with Thomas Lubik, a senior advisor in the Richmond Fed's Research Department about a topic that is on many people's minds these days: government debt and deficits. This conversation will stretch across two episodes of the podcast.

In this episode, we'll focus on why the government may decide to spend more than it takes in and what constraints exist on deficit spending. In the next episode, we'll discuss whether the government should focus on reducing debt or on providing stimulus and assistance when the economy faces a major shock, such as the COVID-19 pandemic.

Thomas, thank you for joining us today.

Thomas Lubik: Morning, Jesse. Thanks for having me.

Romero: Let's start with why we at the central bank are talking about government spending.

When Fed officials are asked about fiscal policy, they generally say that deciding how federal dollars should be spent is the purview of the executive and legislative branches. But, of course, the Fed does care about the course of government spending and debt. Why is that, and how do central bankers factor that into their thinking about monetary policy?

Lubik: In the U.S., like in other advanced economies, there's a strict institutional separation between the monetary authority, the Federal Reserve in our case, and the fiscal authority, Congress. The monetary authority, the Fed, is given monetary policy mandates by Congress but otherwise operates completely independent. In that context, monetary policymakers care about fiscal policy to the extent that the government, besides households and businesses, is an independent actor in the economy, too. The actions of the government affect the path for inflation and employment, which of course the monetary authority cares about. In order to meet the monetary policy mandates the Fed, thus, has to take into account fiscal policy actions and their expected path in the future.

But let me add a somewhat more subtle consideration, namely monetary and fiscal policy are connected in terms of what economists have called the government budget constraint. More specifically, the Fed transfers its operating surplus to the Treasury. This is often loosely called seigniorage revenue, and it is actually revenue for the fiscal side.

This is a little bit of a fun fact that I always like to bring up. This term seigniorage comes from the French word "seigneur" and it basically just means it's the ruler of a geographic area. In the Middle Ages, these rulers would issue coins made from metals such as silver or gold as a means of payment. But when they minted these coins, the seigneurs would often take a cut so that the precious metal content of the coins would differ from their face value. And this is called seigniorage revenue.

In modern economies with a fiat currency system — fiat currency is simply paper money that is issued by the central bank and it is the sole legal tender because the government says so — something similar applies. Like the seigniorage revenue of olden days, the holders of currency are subject to its change in value, namely inflation. The amount of seigniorage revenue, and the way how monetary and fiscal policy are interconnected, is small. In the U.S., it's about $80 billion annually and it has been like that, on average, over the last 10 years. But it's certainly not negligible.

Romero: I didn't know that about the history of the term seigniorage. Thank you so much for sharing that.

So where do most of our tax dollars go and have those shares been stable over time, or have we seen changes in the relative shares?

Lubik: Most of the shares have stayed relatively stable over time. About half of federal spending goes towards what is commonly known as entitlements — that's Social Security, Medicare, Medicaid, other welfare programs. Then, a third of overall spending is so-called discretionary spending and half of that, again, is on military spending. Discretionary spending is determined annually by an appropriations process in Congress.

These shares have stayed largely stable, which was a little bit of a surprise to economists that have studied how the retirement of the baby boomers would raise the share of entitlement spending. This hasn't really happened to the extent that was anticipated.

In the future, a more important component of spending will be the interest on debt that the federal government has to pay. This is now at almost 10 percent of the overall budget. And, of course, with the rising debt levels, this is likely to rise.

Romero: Speaking of budgets, you'll often hear people say that households and businesses have to follow a budget and spend within their means and so the federal government should have to do the same thing. But is this an accurate way to think about government spending?

Lubik: It's a really good question. I would say that this view is not necessarily incorrect, but it requires a little bit more of a different definition [of] what the "means" actually mean.

The government is an economic actor in the economy, just like households, just like businesses. And in economic terms, even the government faces a budget constraint. So it has to figure out what revenues it collects, what the expenditure is. The difference between revenue and expenditure, that's, of course, the budget deficit. The government faces this budget constraint every period annually, so this essentially determines the financing needs of the government.

But it also faces a budget constraint over time, and this is what economists call the intertemporal budget constraint. It is precisely this intertemporal budget constraint that puts limits on the government's means. It's the ability of the government to finance its deficit by selling bonds, Treasury bills to investors. The willingness of investors to buy these bonds essentially puts a limit on the government's behavior.

This is where the concept of the intertemporal government budget constraint then comes into play. It is essentially a forward-looking version of the period-by-period budget constraint. It says that the value of current outstanding debt has to be matched by the present discounted value of the future budget surplus. The future budget surplus includes expected tax revenue, expected spending, expected seigniorage revenue.

In other words if the government, the fiscal authority, needs to finance additional deficits, it has to market this additional bond issuance to the private sector. If the private sector does not expect to be repaid, well, then the government has not satisfied the budget constraint and doesn't have the means to finance additional spending.

Okay, so that may sound a little bit abstract. So, let me compare the differences of what the government can do and what you and I, as individual households, can do when we are managing our finances. There are two key aspects.

First, the government can compel resources from the private sector. The private sector pays taxes [and] is the recipient of expenditure, but it also lends to the government to finance the budget deficit. I, as an individual borrower from a bank, cannot really do this. I can borrow from a bank, but I cannot compel the bank to give me resources.

The second important aspect is that the government creates the means of payments, and that's domestic currency. The fiscal authority can use currency, the means of payment, to pay back debt that has been issued in that currency. As a private citizen, I cannot do this. I cannot create "Lubikbucks" to pay my credit card company. The credit card company wants to see dollars.

Romero: Okay, that makes sense. Thank you for explaining that.

So why would a government spend more money than it's taking in?

Lubik: This is always the key question in fiscal policy and in popular public economics in general. The way I see the government deficit is as a shock absorber.

The government makes spending and taxation decisions, and this is done by Congress. This hopefully lines up with what the voters, what society wants, and is also efficient or optimal. But sometimes there's a shortfall of tax revenue, there's a need for additional spending — the prime example is the current COVID situation — and then the government incurs a higher deficit. The deficit then serves as a buffer or as a shock absorber. In that sense, the deficit prevents worse things to happen in situations like this.

But one can also think about this in a somewhat different way. The deficit is a mechanism to transfer resources across time periods and, thereby, can also help to generate equity across generations. Future generations are likely to be considerably richer than the current generations are. So, we can expect them to contribute to current spending through future taxes.

For instance, when the government invests in infrastructure — it could be physical infrastructure [like] roads, airports and so on, or human infrastructure through research and development, education and so on — this investment is one mechanism that makes these future generations richer. So, we could expect them to contribute to that effort by paying off the debt that the current generation incurred in financing this infrastructure investment. The mechanism [by which] this gets distributed is by deficits and then debt, which is simply accumulated deficits.

Romero: I want to pause there for a second. That's a really interesting way to think about it because I think you so often hear people say, "We're spending money that future generations are going to have to pay back," as if that's in and of itself a bad thing. But we don't often think about the fact that we're spending money now to benefit future generations, so it's not unreasonable to expect that they would contribute to it.

Lubik: I agree with you. I think this is one of the key roles that government fulfills — this equitable distribution of resources between generations. One of the additional aspects of this thinking is that future generations currently don't have a vote in what the current generations' preferences are on what they should spend the additional funds on.

An additional point to consider is whether additional debt issuance finances productive expenditure, such as investment. Then, we could expect future generations to take part in financing this investment by paying off debt in the future. It could be purely consumptive in the form of transfers.

Before the financial crisis of 2008-2009 and before COVID, it was particularly the latter aspect — namely purely consumptive government expenditure — that had economists concerned about the rising debt path in the U.S., since the transfers in form of entitlements and the retirement of the baby boomers were the largest component of that and it was likely to be growing. The danger was that this could crowd out investment, namely the productive investment, and thereby hurt equity between generations. This hasn't really manifested to the extent that was feared, but it is still present.

Let me come back to this COVID issue and equity. There's a lot of discussion about additional government spending in connection with [the] COVID-19 recession. The way I see COVID-19 recession [deficit spending] is as social insurance because it was a shock to the economy that I would argue was largely unanticipated and it was a shock to the entire economy. Social insurance and the additional support spending basically means that society, in the form of government, should contribute to help out those most afflicted by COVID. Higher deficits, higher debt in the future, that basically means that future generations also help out with the support measures for COVID.

Romero: Is there a point at which government debt becomes too high? If so, how do we know when we've crossed that threshold?

Lubik: Yeah, I would say this is the $1 trillion question.

Romero: At least a trillion-dollar question.

Lubik: Yes, it's probably more than a trillion-dollar question.

From an economist's point of view, yes, there is such a point. We'll know it when we see it, we'll know it when we reach it, but by then it's, of course, too late. Let me take a step back and see if I can walk you through some of the thinking that goes into this.

The literature on government debt sustainability is huge. This academic literature has tried to estimate the future path of debt by estimating the future path of tax revenue, government expenditure, seigniorage revenue, money financing and the interest rates on that, future monetary and fiscal policy behavior, and also private investors' expectations and their risk appetites. This exercise in computing the debt limit has a lot of moving parts, so this is not a trivial exercise by any means. But economists have come up with some measures of when too high is too high.

Almost a generation ago, it seems 25 years ago, the conventional wisdom was that, well, maybe a debt to GDP ratio of 60 percent is a level where we might get nervous. This 60 percent debt to GDP ratio actually ended up in the Maastricht Treaty that set the legal foundations for the euro area and which started the integration of the European economies in a common currency. This is still technically in place.

In the pre-Great Recession financial crisis era, we thought that debt levels around 80 percent, 90 percent, 100 percent might be sustainable. At the same time, small open economies that have to borrow in currencies other than their own face more strict debt limits. Nowadays, the thinking goes more towards, well, above 100 percent, 120 percent that may be sustainable, also informed by the situation with rising debt we had after the financial crisis and also with COVID.

What we do know is that debt crises can happen, and they do happen. They happened quite often in the last 200 years of economic history. There are numerous examples of countries that are just blowing through their debt limits, they had to default, they were shut out from world financial markets, and suffered severe economic consequences. However, almost all of these countries in recent history, in the last 50 years, were small, open economies that also were subject to a variety of economic and institutional problems. The most recent example, probably the most concerning one, was Greece during the European debt crisis.

Romero: How about the United States? What signs should we look for that debt levels might have become unstainable?

Lubik: What we would see is that long-term rates, the interest rates on debt, would rise sharply. Foreign demand for U.S. assets would dry up and debt options fail. We haven't seen anything remotely similar to this in the U.S. In that sense, the U.S. debt limit is still untested.

This is also due to an almost unique aspect of the U.S. situation, which I think supports the view that debt levels can be sustainable at much higher levels. There are two aspects to the unique U.S. situation.

Just like Japan, United Kingdom [and] the euro area countries, the U.S. can issue debt in its own currency. So, in principle, the U.S. could pay down its debt by simply printing more U.S. dollars. But that's not a panacea. Unlimited money printing to finance debt basically underlies every hyperinflationary episode in history — the German hyperinflation, the Hungarian hyperinflation in 1946, the hyperinflation in Zimbabwe. However, it is helpful in the sense that if a country can borrow in its own currency it avoids the need to borrow in foreign currency, which has to be acquired through other means, mainly by exporting and receiving foreign currency revenue.

Probably a more important aspect I'd like to point out is that U.S. debt, the U.S. dollar, U.S. Treasury bonds and bills are the world's preferred safe asset. By safe asset, we mean an asset that is highly liquid [and] that can serve multiple purposes. Since the U.S. has the world's preferred safe asset, this puts a floor under the demand for its debt. Banks in Asia like to hold U.S. Treasury bills because they can easily get in and out of them and it's considered not subject to default, not subject to currency and debt crisis. In other words, the world wants the U.S. to run large budget deficits in order to be a supplier of this world's safe asset.

That's also not a panacea, that feature, namely the safe asset feature. Overall, the U.S. dollar's reserve currency status can just as well be lost through, well, rising debt levels.

But let me come back to your question. When do we know when government debt becomes too high? At this point, I wouldn't say that the sky is the limit. But we've certainly tested what was previously considered debt limits. We know from the case of Japan that advanced economies can sustain much higher debt levels.

So, I wouldn't quite say that we are there at the limit. I also would not want to put any number out there. Again, what is still looming are the structural issues with debt, namely entitlement spending and the increased retirement of baby boomers. That is still present. It's likely not going to go away.

Romero: What is the U.S. debt to GDP ratio at present?

Lubik: Um, roughly at 100 percent.

Romero: Okay, getting up there for sure.

Lubik: It is getting up there. There are estimates that we may reach 130 percent in not too long.

Romero: We'll continue our conversation with Thomas Lubik in our next episode of "Speaking of the Economy." In part two, we'll focus on whether the government should spend beyond its means to respond to an economic shock, like the pandemic, or an emerging crisis, like climate change.